What does a weak dollar mean for equity markets?

As the main reserve currency in the international financial system, any explosive weakness in the US dollar can be destabilising for financial markets. We believe this has been one of the main drivers for the recent weakening in equity markets.

Since the end of February 2002 the greenback has fallen by 9% and 7% against the euro and yen respectively. On a trade-weighted basis, the US dollar has now fallen by around 9%-10% since the end of February.

Given such a significant currency move it is worth looking at similar periods in history and the resulting impact on equity markets. We examine two particular periods - 1989 /90, when the US$ fell by around 15% on a trade- weighted basis and 1994 when the US dollar fell by around 12%.

In both cases these periods represented an abrupt break from the trend persisting up until that point and were coincident with significant financial market instability.

Some common observations from these periods are that: US dollar weakness is associated with weakening equity markets. This is not just restricted to the US equity market as it generally produces weaker global markets. Sharp US dollar weakness heightens investor risk aversion resulting in a sell down of risky assets such as equities and buying of risk- free assets such as US government bonds.

As risk aversion increases, correlations between world equity markets increase sharply - the result being that global equity markets fall in tandem with the greenback. The second observation is that as global market indices weaken with the dollar the US stockmarket tends to initially underperform non-US markets.

However, as the economic benefits of a devalued currency are realised (stronger economic performance and corporate profitability) the US market begins to outperform non-US markets in local currency terms.

While significant dollar weakness occurred in both August 1977 and March 1985, these periods were structurally quite different to the present - and are not included in our analysis.

Stagflation, an environment characterised by low growth and high inflation and precipitated by the oil price shocks of the 1970s, produced the dollar correction seen towards the end of that decade. The present US economic environment, meanwhile, is characterised by moderate growth and benign inflation - starkly different to 1977.

The 1985 Plaza Accord - an agreement between the Federal Reserve, Bank of Japan and Bundesbank to weaken a systemically overvalued dollar - resulted, during the mid 1980s, in a sustained and manufactured devaluation of the greenback. The US dollar depreciated over a two-year period to the end of 1987 by approximately 40%, resulting in a massive stimulative boost to US growth, ultimately precipitating the stockmarket bubble (and subsequent crash) in the US in 1987 and Japan in 1989.

The US dollar correction of both 1989/90 and 1994/95 - periods that bear certain similarities structurally with the present - allow us to gain historical perspectives on how world equity markets may react should the greenback continue to depreciate over the coming months.

What they show is that periods of sharp dollar weakness often coincide with stress events and credit shocks - with heightened risk aversion the result. Instability in the international financial system leads investors to seek safe haven assets - such as government bonds - instead of risky investments.
However, once the US dollar stabilises or begins to recover, the historical evidence suggests that global equity markets also start to recover as risk premia start to decline again.

In 1989/90 and 1994/95, a sharp weakening of the US dollar had a destabilising affect on global financial markets. World equity indices tumbled along with the greenback. Equities bottomed as the dollar troughed - only recovering as the trade-weighted value of the greenback rose. This is an interesting observation as it shows the susceptibility of all equity markets, not just the US market, to a weakening US dollar.

Following the 1987 stockmarket crash, money flowed out of equities where expectations had deteriorated and into property. The weakness in the US dollar took hold in 1989 and accelerated this trend.

The US dollar's weakening in 1994 coincided with the collapse in global bond markets with investors fleeing to cash. Equities weakened in line with bond markets and the US dollar. This followed a period from 1991 to 1993 where US economic recovery was sluggish and corporate balance sheet turmoil was extreme, similar to what we are currently seeing. Interest rates had reached multi-decade lows in most economies, again in line with current experience.

It is no coincidence that equity markets follow the downs and ups of the dollar during such stress event periods. Stocks are risky assets, and thus sold across the board as the dollar falls and risk aversion increases. As the dollar rises, and risk aversion abates, risky assets are ascribed a more normal risk premium and tend to rally.

A further important observation can be made of global equity markets' performance in periods of US dollar weakness. While the perception may be that a weaker US dollar will adversely affect the US equity market more than global markets, the evidence is somewhat different.

If we look at the history of relative performance of US versus non-US markets during periods of dollar weakness then we find that US local equity market returns initially lag non-US local equity market performance (Japan, Asia ex-Japan, Europe ex UK, and the UK).

However, this relative performance switches around and ultimately we find that over the medium to longer term the US equity market tends to relatively outperform non-US markets, in local terms, as the devaluation continues.

In both periods of dollar weakness in 1989/90 and 1994/95, the MSCI EAFE - an index comprising all developed markets excluding the US - initially outperformed the MSCI US for a period of between three and six months, respectively.

Following initial underperformance, the US market - during the 1989/90 and 1994/95 periods - managed to outperform the MSCI EAFE by a substantial margin in local terms. The logic of this is that the relative gain in competitiveness from a currency depreciation acts as a spur to corporate profitability and growth for many corporates competing in foreign markets or against importers.

Initial US underperformance is most likely to be a short-term psychological change in investor perceptions of US growth. US equities are sold, with capital flowing to overseas markets - where growth prospects are initially relatively more attractive.
Over time, however, sustained dollar weakness allows the US to become more competitive vis-à-vis its global trading partners. Local US industry becomes more competitive, and exporters offer more competitive pricing in foreign markets. Additionally, profits from overseas subsidiaries of US companies are translated back to more US dollars - which is very supportive for US earnings.

The cycle of US dollar weakness in 2002 is still relatively immature. However, some observations to date include the fact that since February 2002, when the US Trade Weighted Index peaked, the US equity market has underperformed non-US markets by around 4% in local terms. This initially weak relative performance is roughly similar in both magnitude and duration to the US market's performance during 1989 and 1994.

However, should the dollar weaken further or remain around recent levels for an extended period, we might start to see the US market outperforming its overseas rivals. The evidence of the past few weeks suggests that the US market is not losing any relative ground against its non-US rivals.

In conclusion, until there is a bottoming out in the US dollar global equity markets remain vulnerable to further selling pressure and a further elevation in risk premia. The US is initially most susceptible to a plunging dollar, yet over the medium term should benefit vis-à-vis non-US markets as the competitive aspects of a devalued currency are realised.

When the dollar does eventually stabilise, a wholesale shift in risk perceptions should enable investors to push down the equity risk premium - boosting global equities.